I thought I would put out the performance of 40 different markets (compliments of Financial Visualizations) including the stock indexes and interest rate markets for comparison. I find it amusing how some markets that are really outperforming (or underperforming for that matter) are hardly ever mentioned, but could provide great trading opportunities.

Here are the relative performances of those 40 markets in two time frames. The first chart is the performance year to date. The second is the performance over the last 30 days.

I will update these figures on a monthly basis.

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The big question in the bullion market now is China. Is China about to make a large purchase from the IMF? According to Commodity Online “It seems so.” If media reports are to be believed, China has already sealed a deal with IMF to buy 191.3 tonnes of gold, which the monetary fund currently has for sale from the 403.3 tonnes put up for sale since January 2007. 

Whether or not the transaction goes through, the bullion market is going to witness huge volatility. If the Chinese bullion deal goes through as anticipated, it would provide tremendous boost to the sentiment towards gold. China has approximately $2,400 billion as foreign exchange reserves and has been building stocks of gold through domestic purchases as part of asset diversification. IMF deal would add to its already solid gold reserve. 

One thing is for sure, there are some things that are happening now, that have never happened before. The Chinese sovereign wealth funds $155 million investment in GLD is a first.   

Also, as Jeff Clarke from Casey’s Gold and Resource Report points out, The Prime Minister’s Office in India is encouraging state-owned corporations to “aggressively pursue the acquisition of strategic mineral resources.”

“This is telling, both from the perspective that they see some urgency to the matter, and that the acquisition targets are minerals. Given the country’s historic propensity to own gold, it’s not a stretch to think the yellow metal will be high on the list of “strategic investments.” Jeff said. 

Then “Iran is now a nuclear state,” as declared by President Ahmadinejad last week. The Islamic republic is producing high-level enriched uranium, used for electricity and atomic weapons (at 90% enrichment). The U.S. moved to impose sanctions, but it didn’t seem to have much of an impact on Ahmadinejad, who upon hearing the U.S response, said we have no choice but to enrich higher levels and “God willing, daily production will be tripled.” 

No one ever knows how these things will play out, but it sure seems to me that there are some very savvy investors taking rather large positions in gold. In addition to China and India, Soros and Paulson, there is Jim Rogers, Felix Zulaf and Paul Tudor Jones.    

Jim Rogers, who co-founded the Quantum Fund with George Soros, believes that there is no sense in China’s fear of a gold bubble. Rogers has already predicted that gold will zoom to touch $2000 per ounce. He says gold consuming countries like China and India, central bank buying and declining dollar value are driving up gold prices.

Tudor Jones was quoted as saying “Our Precious metals exposure has been increasing and is currently the largest commodity exposure.  As a result we have included, for this quarter, a separate discussion on gold as an appendix.  I have never been a gold bug.  It is just an asset that, like everything else in life, has its time and place.  And now is that time.”  

“As one would expect, rising inflation suggests higher gold prices, especially when the Fed is perceived to be behind the curve. Gold appears to be cheap. In our view, gold’s value should increase as its scarcity relative to printed currencies increases.” 

These are just our viewpoints on some recent developments in the Gold market. Please read “All that Glitters May Be Gold”, a previous post, as those arguments still are valid.

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There seems to be a lot of chatter around the street that Gold will fall due to the dollars recent strength, which the experts say will reduce investment demand. The correlation between the dollar and gold remains firmly in positive territory,” says Barclays Capital analyst Suki Cooper in a note. “Currency movements are likely to lead gold’s price trajectory in forthcoming sessions.” Also the Fed raised the discount rate recently as part of the normalization of lending, according to Chairman Bernanke, but some think this could signal higher rates down the road.

Holdings in the SPDR Gold Trust, the biggest exchange- traded fund backed by bullion, were down about 2.4 percent this year after advancing 45 percent last year. “Investment demand in 2010 is progressing at a more modest pace relative to the second half of last year, judging by more subdued inflows” into ETFs, said Anne-Laure Tremblay, a London- based analyst at BNP Paribas SA.

On the other hand, the widely speculated decrease in investment demand certainly has not kept some major investors from taking very large positions in Gold, particularly GLD, the SPDR Gold Trust.

According to Bloomberg, billionaire George Soros’s of Soros Fund Management LLC, more than doubled its holding in the biggest gold exchange-traded fund in the fourth quarter, after bullion advanced 8.9 percent to a record.

“The $25 billion New York-based firm became the fourth- largest holder in the SPDR Gold Trust, adding 3.728 million shares valued at $421 million, according to a filing with the U.S. Securities and Exchange Commission yesterday. Its investment was worth about $663 million, the fund’s largest single investment, as of Dec. 31.

Soros was quoted earlier as saying, “Considering the extent of the oil price decline, gold has remained very resilient as we predicted. Big money interests realize that the long term gold/ oil ratio favors higher gold prices and or lower oil prices.” The current gold to oil ratio is approximately 14 to 1.

Also there has been a steady decrease in mine production, especially South Africa, where mines have gotten too deep and dangerous to produce like they did in the past. Unfortunately, the rest of the world has not made up the difference. World output has fallen by 1 million ounces annually since 2001 and the problems in Chile won’t help.

Chile is the world’s largest producer of copper. It has the world’s most productive mine at Chuquicamanta. Northern Chile also has rich, high-grade iron-ore deposits, mainly in the Coquimbo area. Most of the ore is exported, and the rest is used by the local iron and steel industry. Chile is also home to American Barrick’s massive Pascua-Lama gold and silver project, Kinross’ Lobo Marte, and their joint venture project at Cerro Casale. Chile could be facing problems in the coming months and this will impact its almost all mining operations. Apparently the 8.8-magnitude quake displaced more than 1.5 million people and severely damaged 500,000 homes.

The China Investment Corp and the central banks of China and India also have been acquiring gold through the ETF. China Investment, the $300 billion sovereign wealth fund based in Beijing, took a 1.45 million-share stake in the SPDR Gold Trust worth $155.6 million, according to a SEC 13F filing posted on Feb. 5.

“The dollar is weak and people are just shifting their money into a safer haven,” Tetsuya Yoshii, vice president for derivative products at Mizuho Corporate Bank Ltd., said from Tokyo today. “Central banks are adding gold to their reserves and we’re going to see more people adding gold to their investment portfolio as they shift into safer stuff.”

Institutional investor Paulson & Co. held the largest number of shares of GLD as of Dec. 31, with 8.65 percent, or 31.5 million shares. In addition to that, he has launched a Gold Fund that he put an incredible $250 million of his own money into. Now, Soros has upped his stake in GLD to $663,000,000 and China owns $155,600,000 of GLD.

These are some new developments in the ETF market. In addition to this, India bought 200 metric tons of gold from the International Monetary Fund in the bullion market (half of what they were offering), and China could be ready to do the same.

This will be discussed further in part 2.  View Related Post Here

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Here are a few viewpoints from Larry Hite and Salem Abraham on managing risk and expecting the unexpected. You can not only be wrong, you can be totally surprised on occasion.

Larry Hite, one of the original “Market Wizards” was quoted On Michael Covel’s site as saying, “Most of the Ivy League guys I know are so used to being ‘right’ they get very uncomfortable dealing with uncertainty – when there is no right answer.

Their ego often makes them so afraid of being ‘wrong’, that they’re unable to make good bets. They are not comfortable with the idea of risk, because they don’t know how to assess it or measure it. [They have been] taught to absorb knowledge, not what to do with it.

There are just four kinds of bets. There are good bets, bad bets, bets that you win, and bets that you lose. Winning a bad bet can be the most dangerous outcome of all, because a success of that kind can encourage you to take more bad bets in the future. You can also lose a good bet, but if you keep placing good bets, over time, the law of averages will be working for you.”

Below, Salem Abraham, who was also an original “Market Wizard,” talks very briefly on risk and expecting the unexpected.

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What bothers me is how will we handle another round of re-sets on top of the other problems I touch on in part one,  especially when they are the even more esoteric “Option Arms”?

Jim says “this second wave will come crashing even harder than the first. It’s made up of a type of mortgage called "Option ARMs." These give borrowers the option of how much they want to pay during the first five or 10 years of repayment. You can pay the full amortized rate, including interest and principal or Interest only, or, a token payment, well below the amount needed to cover the interest on the loan. This third option causes the mortgage balance to INCREASE instead of decrease. And usually, the borrower can continue to make minimum payments until the mortgage balance increases to 125% of the original amount. That’s when the trouble begins…especially if the interest rate increases at the same time. This is the exact situation in which many homeowners now find themselves.”

According to Whitney Tilson and Glenn Tongue of T2 Partners, who are experts on this subject, about 80% of option ARMs are negatively amortizing. Meaning these so-called top-tier borrowers are heading further into the hole. Once their rates reset, they could be in serious trouble.

 Jim goes on to say “The chart above shows the two peaks in the mortgage-reset wave. The first peak is comprised of subprime ARM resets. And the second is mostly constructed of option ARM resets. We appear to be in the eye of the storm.

That fact alone shook our nerves when we first discovered it. But it was a different chart in Tilson and Tongue’s most recent presentation that really got us startled… It’s also the reason I’m predicting the dollar spike in 2010.

Instead of resetting as expected after the first five years, many option ARMs are so negatively amortized that they are hitting their automatic reset cap.

 As you can see from the second chart, the expected reset peak was to occur in 2011. But the real peak is happening now. You can also see that the amount of mortgages resetting is spread over a longer period of time than originally thought, but is peaking much earlier. Unfortunately, it’s not the peaks that matter.

You see, those are just resets. But with unemployment reaching quarter- century highs every month, and the massive number of homeowners about to receive mortgage bills for two to three times what they are used to paying, we find ourselves in an even scarier environment than this time last year.

It takes anywhere between 3-12 months for most homeowners to actually go into foreclosure. Therefore, the wave of Option-ARMs that are now resetting could cause a major wave of foreclosures over the next 6 to 18 months. It’s tough to say exactly when the storm will come. But my guess is the second half of 2010. This second wave of foreclosures will not be good news for the economy or the stock market…At least that’s my guess.”

For those interested take a look at the ProShares, UltraShort Real Estate ETF (Symbol: SRS). This ETF seeks daily investment results that correspond to twice the inverse daily performance of the Dow Jones U.S. Real Estate Index. In other words this ETF would rise twice the amount that the Dow Jones Real Estate Index would fall.

When the real estate stocks were plummeting in November of 2008, SRS traded at over $200.00 per share. Now it trades at around $7.50-$8.00 per share.

Who knows what will happen, the markets have an uncanny ability to fool us. That aside it’s good food for thought.

It appears to be a good speculation as these real estate stocks go through some kind of correction. If it’s not the bottom of our real estate problems, and turns out to be a bear market rally, it could turn out to have some real upside.

A good speculation, great leverage at 2x the index and low risk (maximum 8 points if it traded down to zero)

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With lending as tight as it’s been in lending history, and unemployment at 10% (so they say, probably more like 15%), where are the prospective buyers supposed to come from? If you throw the proposed HUD legislation to prevent owner financed deals unless the owner lives in the property, the picture gets even bleaker. Then there are those pesky ARM resets coming up this year, bleaker yet. 

Research shows where roughly five million homeowners- houses and condos- are delinquent and headed for foreclosure. If we don’t recover quickly and interest rates rise, prices would fall even further and drive more owners in default to foreclosure. In fact, Standard & Poor’s sees the “overhang” of foreclosed homes leading to as many as 70% of owners in default to foreclosure. Not a pretty picture. 

As if these troubles aren’t enough, we are also dealing with escalating lumber prices. Lumber, strangely enough, is outperforming the S&P, Gold, Copper, Grains and Oil this year. In fact it’s outperforming most things. This is great if you own lumber futures, but not so great if you’re looking for help with the housing market.  

Lumber is up over 25% this year despite the home construction business – its main use – at record lows.

According to Jon Markman at Money Morning, “This is a rather stunning development. But there’s a solid explanation: Production has dropped in the face of weak demand – and dropped so much that prices have moved much higher. In other words, because there has been so little demand for lumber to build houses, timber companies have cut back on their harvesting and cutting. So now that home production is picking up a little – as was suggested in some earnings and economic reports last week – marginal new demand is pushing up the price of this surprisingly scarce commodity. “Now, in the face of all these obstacles how in the world did the homebuilder and real estate stocks soar? What do they know that we don’t know, or is this just a great opportunity to short them? To shed some perspective on the advance the SPDR S&P Homebuilders (NYSE: XHB), which replicates as closely as possible the performance of the S&P Homebuilders Select Industry Index, has doubled from its March 2009 low. 

Is this really sustainable?  

Michael Schulman of Seeking Alpha has been warning us since 2007. He says way too many houses were built and that “40% of the jobs created between 2000 and 2008 were in home construction.” Also, as we know, houses were sold to people that could not afford to own a house, but were enticed by the creative mortgages, which led to the housing crash and the current recession. 

Recently Schulman said “One quarter of the people in the US with a mortgage now has a mortgage greater than the value of their home. And for this reason, for the first time ever, the people in default on their homes are paying credit card bills before paying mortgages. Mortgage lending standards are tighter than anyone can remember. There is no secondary mortgage market and only Fannie Mae and Freddie Mac are buying mortgages. But they are capped at how much they buy, could hit the cap next year, and between this cap and the Fed withdrawing from buying mortgages, rates will have to rise to bring other buyers of RMBS into the market. Put this together with the continuing slide in home prices, and you have another seven million foreclosures coming in the next 30 months and reduced demand for new and existing homes.” 

The only bright spot is that evidence shows that a low in lumber prices coincides with relative lows in the construction of new single-family homes, 12 months out. Fortunately, we did see a low in lumber prices set a year ago in January 2009, which would suggest that single-family home construction is right now at a relative low. Other than that, and the T.V. saying we have bottomed, I don’t see much of anything that would turn this battleship around. 

Stay tuned for part two tomorrow.

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Now, I would assume that Ben Bernanke has a research staff, and access to information, that would dwarf our capabilities, not to mention he can call anyone he wants on the phone and pick their brain.

So, in light of that, how in the world could he have been so wrong with such a high degree of confidence?

This is just another example of the “expert” arrogance. The old “I’m right so why should I have a plan B” way of thinking. On a brighter note, it is more evidence of a few things I know to be true.

First, it is extremely difficult to predict and forecast large systems such as the financial markets or the economy, no matter how many facts you think you have.

Second, if with all his resources he can be this wrong, that doesn’t bode well for the rest of us who might be going about the markets in a similar fashion.

Third, it’s OK to have an opinion (forecast) if you firmly believe, but it’s not OK to bet the farm and have no real plan to manage the situation if you’re wrong.
 

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Those that have knowledge don’t predict. Those that predict don’t have knowledge – LAO TZU 

What criteria did you use to choose your latest investment? A better question would be, are you sure that you even understand the criteria? 

For example, let’s say that you chose a mutual fund based on your advisors presentation of how well managed the fund is, and the fact that it has done so well over the last x amount of years. He then assures you it will do well into the future based on the past facts. On the surface this seems reasonable until one considers a few undeniable facts. One, the advisor really has no idea of the future, and two, the performance could be random.  

In fact, history proves that the average mutual fund over the last 25 years has grossly underperformed the market averages. Keep in mind that the advisor is in the business of showing you products that compete with the averages, and is not paid to guide you into something as simple as “buy the S&P.” Also, the fund managers themselves continually compete with the averages, selling their “expert” forecasting as better mousetrap. 

In their book Dance With Chance, Authors Spyros Makridakis, Robin Hograth & Anil Gaba point out a rather astounding piece of research. I think most people have heard that the fund managers don’t out perform the averages in the long run, but I’m not sure that they know to what degree. 

According to the authors, if a person had invested $50,000 into the market average (S&P), 25 years ago they would have 1,061,527 today. The average Index fund (those that track the S&P) would have sent you back 1,015,541. Pretty close. However the same $50,000 in the average mutual fund would have sent you back $541,735. Not so close. 

The significance of this is that the S&P is not a person and therefore can’t claim any expertise. It is essentially the growth of 500 companies. On the other hand the fund managers do claim the expertise, but can’t really seem to deliver it.  It’s amazing how people continue to fall for this, but I suppose the lure of large returns is just too strong to resist. 

When one considers the survivorship bias for those that actually did outperform the averages, the picture becomes even dimmer. In other words, many of the funds that have outperformed the averages still cannot be attributed to skill. Some for sure, but not all.  

To make my point simple, consider a scenario where 1000 manages have a 50% chance of beating the S&P in a particular year. After one year there would be 500 that did. By the fifth year there would be 31 that have beaten the S&P five years in a row. Pretty impressive, but still cannot be attributed to skill.  

After 10 years there will be one manager, from sheer luck, that will have beat the S&P for ten years in a row. The last man standing, the survivor so to speak. Very impressive, but still luck. Past and future performance simply are not related, therefore chasing past success should not be the primary reason to invest.   

What is even more astounding is the “I’ll do it myself crowd.” The average investor investing on his own, according to the research, ended up with $271,371. In other words if the average investor just stayed with the S&P he would have had 4x the amount of money. This could be the difference between financial freedom and “I owe, I owe, it’s off to work I go.” 

I guess this is one walk of life where many of us wish we were just average. 

John Kenneth Galbraith once said “when it comes to the stock market there are two kinds of investors. Those who don’t know where the market is going, and those that don’t know that they don’t know where the market is going.” 

I guess people will draw different conclusions from the above statistics, but I agree with the author’s conclusion. DON’T TRY TO BEAT THE AVERAGES. If you are a stock market investor buy the S&P (or another index or ETF), the numbers speak for themselves.  

If you like gold mining companies buy a mining index (ETF) and don’t try to find the company that will outperform the index (many mining companies). It appears that our odds of choosing the fund, or stock, that will consistently beat the indexed averages is practically impossible. 

Also BE PATIENT the authors say. People just don’t seem to exercise the patience that is required to do well as a investor. Don’t give into the temptation to try and sell the highs and buy back later, or quit your trend following system because it had a sluggish year. The average investor will fail at this. Play the probabilities of long term growth and trends. 

Finally be RISK AWARE, the area that I think is the most important. This does not mean risk-adverse. It means realize that what you don’t know is always greater than what you do know….. and manage your risk accordingly.   

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Forecasting is a very difficult thing to do, especially in such dynamic and complicated systems like the financial markets. It does seem however, that some are better than others when it comes to predicting.

Felix Zulauf is the founder of Zulauf Asset Management based in Switzerland and is well known for his appearances in Barron’s annual roundtable. Zulauf has nailed the secular bear market downturn and 2009 upturn about as well as anyone.  More importantly, he has been nearly flawless in connecting the dots in the macro picture.  From the de-leveraging cycle that led to the downturn to the government stimulus that led to the upturn – Zulauf has been remarkably prescient.

At the 2008 Barron’s Roundtable, Zulauf recommended investors purchase gold and short stocks due to concerns with the consumer.  He remained bearish throughout the year.  At the 2009 roundtable Zulauf said stocks would bottom at some point in the second quarter after making a new 2009 low.  He got aggressive and said stocks would rally after that.  His recommendations to purchase oil, gold and emerging markets were home runs.

Here are his recent comments from the 2010 roundtable:

“We are in the early stages of a deleveraging process, which is marked by a shift from maximizing profits to minimizing debt. It is a multiyear process. The U.S. consumer is in bad shape, and the U.K. consumer is even worse.”

“Central bankers themselves are somewhat afraid of what they have been doing. Politicians are worried about public-sector debt. Therefore, the authorities will try to step away slowly from their stimulation efforts, because this policy isn’t sustainable. That’s the risk for the markets.”

“The U.S. stock market has enough momentum to rise another 10% or so. But the authorities will start leaning the other way as they see signs of economic growth in the first two quarters, and possibly a jump in inflation. That could push the market down.”

“China is in a dangerous situation. Credit growth is the one factor that all the bubbles that burst had in common. Because China isn’t an open economy, the bubble there can probably keep inflating longer than it otherwise would have. But the Chinese can’t escape the laws of economics. If China’s bubble bursts, it would cause a second hit to the world economy, and that would be terrible.”

“In the past five years, the individual investor has been hit by two bear markets in stocks and a severe bear market in housing. He is just done. You see it in fund-flow statistics. Money is flowing into fixed-income investments that are perceived to be safe.”

“The euro is about 20% overvalued relative to the U.S. dollar. It could trade down to $1.25, from $1.45. You can see how the weaker members of the European Union are getting squeezed.”

“Governments and central banks will continue to support the economy. Short-term interest rates will stay low.  Bonds aren’t attractive.”

“Previously I advised buying financials and metals. Now the financials are done, perhaps for a couple of years. Bank balance sheets aren’t repaired. It’s just camouflage. Today I like emerging markets and natural resources.”

“The real danger comes from mid-2010 through 2011. This won’t be a conventional business-cycle expansion, but a bumpy road. The economy will look like a square-root sign followed by corrugated sheet iron. The good news is the potential collapse of the system has been avoided. It was an open question for a while.”

“We’ll enter another bear-market cycle. I don’t know how low it will go. In March the market made a cyclical low in valuation, but it wasn’t a secular low. When the market makes a secular low, lack of interest in equities will be high.”

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